Average Profit Method

EconomicsArticles / Tutorial Titles

Introduction

The average profit method is a method of calculating the goodwill of a company. Goodwill is of immense value to a company.

Although goodwill is an economic term, it is widely used in finance as a measure of extra valuation for a company, especially during its sale. The owners may take various steps to calculate the value of goodwill but all methods usually provide the same value of goodwill.

What is Goodwill?

Goodwill is an intangible asset. It is associated with the purchase of one company by another. The extra value of a company that remains after the net fair value of all assets and liabilities assumed in the purchasing process is known as the goodwill of the company. Some of the components of goodwill include a solid customer base, the value of the brand name of the company, good employee relations, etc. These components show why goodwill is important and present in a company and is of very high importance during the sale of a company.

Although the process of measuring goodwill is simple and straightforward in theory, in practice, it is cumbersome. To determine the goodwill of a company in theory, the net fair market value of all identifiable assets and liabilities should be subtracted from the purchase price of a company.

The idea of goodwill actually arises when a company buys another. The buyer has to pay the company for sale a price that is more than the assets and liabilities combined. This extra price is known as goodwill. In fact, a company is not just made of physical goods. It contains intangible assets such as reputation, the value of its brand, and technological propriety that cannot be measured directly while calculating the assets and liabilities.

Goodwill is recorded as an intangible asset on the balance sheet of companies. According to International Financial Reporting Standards (IFRS) companies must evaluate the value of goodwill on their financial statements at least once a year. Goodwill is not physical in nature and so it is an intangible asset.

Valuation of Goodwill

In general, companies in business do not just build or create intangible assets in the course of business activity in the market. They have to earn a good name, build trust with customers and strengthen their brand value to make their business stronger. These activities add value to the businesses’ overall values.

For example, the restaurant chain KFC is known for its quality products all over the world. It has earned a brand name in the market for its product quality which makes it a better option than any other similar restaurant selling similar products. So, the value of KFC will be naturally higher than similar companies even if the latter has the same assets as KFC. So, KFC will be valued much higher than a similar company due to its brand value. This shows the power of goodwill of the companies.

So, we can state that goodwill is an extra value of a company that is earned during doing business well. This extra value may come from different aspects but they all add value to the company’s overall value. In some cases, the value of goodwill is so high that the companies may find it hard to measure the value of goodwill in a simple process.

As in the case of KFC, it is apparent that the restaurant chain offers an advantage via its brand name. The potential buyers, if any, of the chain will have to pay worth the advantage extra to the restaurant chain in case of an acquisition. The monetary value that a buyer would be ready to pay for this extra value is known as goodwill.

The buyer who pays for goodwill assumes that he may earn super profits from the goodwill and not just normal profits.

The need for valuation of goodwill arises at the time of

  • Change in the profit sharing ratio amongst the existing partners
  • The retirement of a partner
  • Admission of a new partner
  • Death of a partner
  • Dissolution of a firm where business is sold as a going concern.

Calculating Goodwill: Average profits Method

Following average profit methods are used can be used in calculating Goodwill −

Simple Average

In this method, the goodwill is valued at the determined number of years of the purchase of the average profits of the past years.

The formula of goodwill in the simple average method is

$\mathrm{Goodwill = Average\: Profit \times No.\: of\: years\: of\: purchase}$

Weighted Average

In this method, the goodwill is valued at a pre-set number of years of the purchase of the weighted average. These profits are from the past years. The weighted average process is used when there is an increasing or decreasing trend in the profits. In such as case, the highest weight is given to the current year’s profit.

$\mathrm{Goodwill = weighted Average Profit \times No. \:of \:years \:of\: purchase}$

$\mathrm{Weighted\: Average\: Profit =\frac{Sum\: of\: Profits\: mutiplied\: by\: weights}{Sum\: of\: Weight}}$

The average profit method is one of the most widely used methods for calculating the goodwill of a firm. As past profits are available from financial statements, it is easier to measure goodwill in average profit method than other methods.

Conclusion

The average profit method is an easy and reliable method to calculate the goodwill of a company. The purchasers use the average profits earned in the past years and then determine the average goodwill of the company using the agreed terms. The average profit method can be used to evaluate profits of forms from all types of industries as it is not dependent on the types of assets.

Moreover, there is no need to consider the value of assets differently as they are included in the calculation of profits that is used in the formula to calculate the average profit of the firm. The average profit method offers a quick way to calculate the value of goodwill and there is nothing too complex in calculating it.

Buyers usually pay enough attention to derive the right value of goodwill of a firm they are intending to buy. Depending on the value of goodwill, the final value of a firm is established. Therefore, goodwill is an important measure to verify the ultimate value of a company and it will remain one of the key aspects of the valuation of firms forever.

FAQs

Qns 1. Mention the steps involved in the average profit method calculation of goodwill.

Ans. Steps involved under Average Profits Method are

  • Step 1 − Calculate the past profits before tax.
  • Step 2 − Calculate the future profit before tax after making the past adjustments.
  • Step 3 − Calculate the average past adjusted profits.
  • Step 4 − Multiply the future profits to be maintained by the number of years’ purchase.

Qns 2. What are the other methods of calculation of goodwill?

Ans. Some other methods of calculating goodwill are Super Profit Method, Capitalization Method, and Annuity Method.

Qns 3. What is meant by an intangible asset? Is goodwill an intangible asset?

Ans. Assets that are not physical in nature are called intangible assets. Goodwill cannot be physically felt, so it is an intangible asset.

Qns 4. Why do, in general, a buyer pays for goodwill while buying a firm?

Ans. A purchaser pays the value of goodwill to earn super profits by purchasing the firm, not just normal profits.

raja
Updated on 13-Oct-2022 11:19:47

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